Investors Are Piling Into Loans That Banks Have Avoided Since the Crash

Jordan Selleck missed the grisly end last time, the Lehman moment that punctured the great American bubble in real estate, credit and foolishness.

He was a year out of college back in 2008, when excessive leverage caught up with Wall Street and the rest of the economy.

But memories can be short, especially in the financial markets. And Selleck, 34, is carving his initials in the latest American debt machine. Lots and lots of debt.

It’s private credit, and it has transformed the oldest game in banking: loans. In the decade since the crisis, investors have poured vast sums of money at companies that are generally too small or too risky for sober bankers.

What began guardedly, as traditional lenders retreated post-Lehman, has exploded into a financial-industrial complex rapidly approaching $1 trillion, with money streaming in from pension funds, insurers and hedge funds. It’s part of a decade-long borrowing spree that has swelled the world’s supply of credit to private businesses to 98 percent of gross domestic product. But instead of big corporations, this lending boom is filtering down to small-town or regional businesses looking to cash in as money managers and private equity firms fan out across the country.

Amid the furor, Selleck has found his play: a sort of Tinder for corporate credit. In barely two years, more than 470 different potential lenders have signed up to his match-making web site, DebtMaven. For a small fee, he connects them with smaller companies looking for money.

“They’re hooked on deal flow and willing to pay,” Selleck says of his lenders. “It’s grown at a crazy pace.”

That pace is now raising red flags among regulators and central bankers, who fret that the direct-lending industry is helping to fuel a global credit bubble that’s leaving the economy increasingly vulnerable. Reaching for anything that pays decent returns, investors have been pouring money into all sorts of risky assets. Not since the heady days of 2007, when private credit was a relative backwater, have the rewards for holding riskier debt like junk bonds seemed so meager.

So why is private credit so beguiling? One word: yield. A decade of central bank stimulus caused it to evaporate in the usual places, such as the debt of blue-chip corporations. If everything goes according to plan, loans from private lenders are usually more lucrative than those to bigger companies. They hold out all-in yields of 7 percent to 9 percent, sometimes much more. That compares to an average 4.3 percent for the typical investment-grade corporate bond.

What’s an Investor to Do?

Pre-crisis, there was a smorgasbord of investment-grade corporate bonds paying 5 percent or more—most of which carried the highest ratings. Now, after a decade of ultra-low interest rates, finding that kind of yield has become difficult.
  • Rating:  BBB
  • AA 
  • AAA 

2006

$1.9T

1,034 issuers

Federal Home Loan Banks issued $270.6B in 2006. That’s more than all investment-grade bonds issued in 2018 that pay at least 5 percent.

2018

$166.3B

175 issuers

Petroleos Mexicanos issued $14.7B, the largest amount for 2018.

2006

$1.9T

1,034 issuers

Federal Home Loan Banks issued $270.6B in 2006. That’s more than all investment-grade bonds issued in 2018 that pay at

least 5 percent

2018

$166.3B

175 issuers

Petroleos Mexicanos issued $14.7B, the largest amount for 2018.

2006

$1.9T

1,034 issuers

Federal Home Loan Banks issued $270.6B in 2006. That’s more than all investment- grade bonds issued in 2018 that pay at

least 5 percent

2018

$166.3B

175 issuers

Petroleos Mexicanos issued $14.7B, the largest amount for 2018.

2006

$1.9T

1,034 issuers

2018

$166.3B

175 issuers

Federal Home Loan Banks issued $270.6B in 2006.

That’s more than all investment-grade bonds issued in 2018 that pay at least 5 percent.

Petroleos Mexicanos issued $14.7B,

the largest amount for 2018.

Source: Bloomberg compilation of corporate-bond offerings each year with coupons of 5 percent or higher and an investment-grade rating from S&P Global Ratings, the biggest bond ratings firm. Debt amounts are aggregated by issuer and ratings tier, so issuers with bonds across multiple ratings tiers will be represented by multiple bubbles.

And so money has poured in. In the past 10 years, private funds that lend directly to companies have raised almost $500 billion, according to data compiled by Bloomberg. Another $100 billion has been amassed by publicly traded lenders known as business development companies, giving even small-time stock investors a chance to get in on the action. Altogether, an industry group has estimated that the market would hit the trillion-dollar mark by 2020.

Even the financial engineers are getting to work. So far this year, Wall Street has churned out almost $20 billion of collateralized loan obligations that transform those often risky loans into securities rated as high as triple-A.

The frenzy has turned lending startups into heavyweights almost overnight. Owl Rock Capital Partners—a New York firm founded by Blackstone, KKR and Goldman Sachs veterans—has amassed $9.5 billion of assets since it started in 2016.

Money raised by Owl Rock found its way to the outskirts of Charlotte, North Carolina, where it helped fund the buyout of Carolina Beverage Group by Cold Spring Brewing Co., a craft-beer producer owned by private equity firm Brynwood Partners. Owl Rock’s financing amounted to almost $45 million.

TransPerfect Global Inc., a New York-based language-service company, borrowed about $262 million from Owl Rock to help one of its founders buy out the shares of the other after they had a falling out. That debt pays more than 9.5 percent. They’re among loans Owl Rock has arranged for companies with typical earnings before interest, taxes, depreciation and amortization of $10 million to $250 million annually.

Whom to Call When the Bank Says No

Since the crisis, private funds have raised hundreds of billions of dollars to make loans to small and mid-sized companies.

$100B

75

50

25

0

2012

2014

2016

2010

$100B

75

50

25

0

2009

2011

2012

2013

2014

2015

2016

2017

2010

$100B

75

50

25

0

2009

2011

2012

2013

2014

2015

2016

2017

2010

Source: Bloomberg-compiled data from private funds that make loans and mezzanine debt investments. Does not include some types of private-debt funds, such as business development corporations. At least $41 billion has been raised so far in 2018, but that data only includes funds that have officially closed.

But as investor money keeps rolling into private debt funds, the juicy premiums that lured them there have been slowly vanishing, and investor protections known as covenants have been eroding. One measure of the premium investors gain by investing in private debt versus public capital markets has shrunk from about 3 percentage points in 2009 to about 0.5 percentage point today, according to advisory firm Willis Towers Watson.

To private-debt pros, that’s a recipe for big losses. Ares Management, one of the biggest and most experienced players, has been involved in private credit for a decade and a half. Its chief executive officer, Michael Arougheti, rolls his eyes at some of the risks that newbies are taking.

Sure, maybe you can make 8 percent and get your money back—if you’re right, he says. But, if you’re wrong, the downside can be huge. “A lot of people don’t fully appreciate that, so they stretch on risk, thinking they’ll get more upside,” Arougheti says.

Don’t think that the risk stops with private lenders. Like many of its peers, Owl Rock gets credit lines from banks, in this case five financing facilities of about $2.6 billion. That includes a $900 million credit line from Wells Fargo & Co.

Owl Rock holds its loans on its books. But other lenders, such as the debt unit of KKR and credit manager Antares Capital, often flip a portion of the debt to yield-seeking investors such as pension funds, endowments and sovereign wealth funds.

For outsiders, the workings of private credit are often a mystery. Unlike bonds, private loans aren’t generally traded in the open market. Credit ratings? Unlikely. The extent of any damage may only become apparent when a reckoning arrives and investors are left with something that’s hard to sell.

The Rise of the Shadow Banks

Non-bank intermediaries such as private equity firms and hedge funds have been making up a greater share of global financial assets since the financial crisis.

Great Recession

Share of global financial assets

50%

45

40.5%

Banks

40

35

29.4%

Non-bank

intermediaries

30

25

2008

2016

Great Recession

Share of global financial assets

50%

45

40.5%

Banks

40

35

29.4%

Non-bank

intermediaries

30

25

2008

2009

2010

2011

2012

2013

2014

2015

2016

Great Recession

Share of global financial assets

50%

45

40.5%

Banks

40

35

29.4%

Non-bank

intermediaries

30

25

2008

2009

2010

2011

2012

2013

2014

2015

2016

Source: Financial Stability Board's Global Shadow Banking Monitoring Report (March 2018)

The risks—for investors and companies alike—will likely grow as interest rates keep climbing. And they’ll be more acute for small and midsize businesses that borrowed heavily in good times.

“It has the seduction of offering the appearance of both higher returns and stability, because it doesn’t have to mark-to-market, and it doesn’t trade,” Steve Vaccaro, chief executive officer of CIFC Asset Management, says of private credit. “But some companies are over-banked and over-levered and prices are likely to move substantially if there is a problem.”

Others have been more blunt with their warnings. Dan Zwirn, chief executive officer at Arena Investors, a New York firm that lends to firms less able to access conventional sources, says the boom will probably end like the others: with finger-pointing and litigation.

“There will be recrimination and litigation, and cries of ‘I was fooled’, ‘I didn’t have the information’ and ‘You took advantage of me,” Zwirn says. “When, in fact, the data, as with the mortgage crisis, was right in front of our faces.”

Private debt firms including Owl Rock and Churchill Asset Management, a New York-based lender that has closed more than 550 loan deals since 2006, say they understand the risks and how to navigate them.

Churchill’s CEO, Ken Kencel, steers clear of pockets of the market where discipline is slipping. He lends to mid-size U.S. firms where loans are senior-secured, meaning he’s first in line for payouts if the firm defaults. He lends to borrowers with strong cash flow, plenty of equity and junior debt that serve as buffers if the firm hits a bump. He’ll average an all-in yield of 7 percent to 7.5 percent.

“It’s a pretty good space to be in,” Kencel says.

Owl Rock’s executives say there are plenty of deals that the lender is refusing to stretch on. The firm has only done about 3 percent of some 2,600 deals it’s seen, according to one of its founders Marc Lipschultz, a former KKR dealmaker.

“Any day of the week we will trade spread for safety,” Lipschultz says. “Of course not everything is going to work perfectly: but the key is to have very few things go wrong and when they do, you still get your money back.”

Back at DebtMaven, Selleck strikes as a startup guy. On a recent afternoon, he was wearing a DebtMaven T-shirt, shorts and baseball cap, and cradling his 2-year-old daughter, while discussing the ambitions for his business.

He says lenders on his site might eventually embrace a “swipe right” strategy a la Tinder. DebtMaven went live in mid-2017 and made its first match in August, between a female-run private equity firm in Chicago that was looking and Avidbank, a specialized lender in San Jose, in a deal that cut costs, work and time, says Selleck.

He’s aware some will end up getting burned and he’s turned down companies that look like they’re borrowing too much, as well as lenders that seem like “bad actors.” People are considering deals they wouldn’t have touched 12 or 18 months ago, he says.

“In a market that is hot, for the sake of getting the deal done, they might not do as much diligence,” he says. “That’s the risk for lenders.” And, in private credit, for those lenders’ investors, too.